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Before Buying That Hot IPO…

Initial public offerings (IPOs) are supposed to represent the Holy Grail. It’s your chance to own the next Microsoft or the next Google. But is it really your lottery ticket to riches?

Here’s what usually happens: People buy stocks at the wrong price hoping for a quick gain and more frequently end up with quick losses.

Social media stocks are 2012’s poster child for what can go wrong. Overhyped IPOs like Facebook (FB), Zynga (ZNGA) and Groupon (GRPN) were promoted as a sure thing. Since its May debut, Facebook has already lost more than half its value and Zynga AT around $2.50 per share is now practically a penny stock. As a group, social media stocks (SOCL) lagged the broader stock market by around 12%.

Does that mean IPOs are a bad investment? Not necessarily.

Since 1980, the average first-day return for IPOs has been 18%. But here’s the problem: Those returns are based upon buying the IPO at the stock’s offer price and selling it on the first closing day. Most investors can’t buy IPOs at the offer price, because only the underwriters’ favorite clients are given that chance. Instead, investors have to buy the IPO in the public market, usually after its price has already “popped.”

Does buying and holding an IPO improve your odds of making a profit? Not necessarily.

More than 50% of the IPOs over the past three years lost money during the first three and six months of trading. Here’s another fact: The odds of losing a large amount of money (more than 10%) jumped in moving from three- to six-month holding periods. This could be due to the lock-up period, which is generally between 90 and 180 days when company insiders are restricted from selling their shares. After the lock-up period expires, downward pressure on the stock can follow.

For longer-term investors, here are more sobering numbers: The three-year buy-and-hold returns for IPO stocks lagged the average three-year cumulative returns of similar non-IPO stocks by 7.4% from 1980 through 2011, according to data from Professor Jay Ritter of the University of Florida. His research also showed that, from 1970 to 2010, IPOs have underperformed similar non-IPO stocks by an average of 1.8% per year during the first five years after issuance.

Interestingly, there have been some disconnects with the intermediate performance (five years) of IPOs easily beating the broader stock market.

Over the past five years, the First Trust U.S. IPO Index ETF (FPX) has gained 14.60% compared to a 6.52% loss for the S&P 500 (SPY). FPX’s index includes the 100 largest and most liquid U.S. IPOs. Holdings are given a 10% cap and holdings are rebalanced quarterly. FPX’s annual expense ratio is 0.60%.

In summary, unless you’re a corporate insider or an underwriter, IPO investing isn’t a get-rich-quick strategy. For every Google, there’s an ocean of losers.